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Educational Article

The Other Side of The Strategy

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In the past, I've written several articles on the strategy of writing 'covered calls' against LEAPS, as a way to lower the cost basis of the long LEAP Call. In essence, this strategy consists of buying a LEAP call on a stock and then writing front-month calls against that LEAP (which takes the place of the long stock in the 'covered call' strategy. While the term covered call is functionally correct in terms of what we are doing, the real term for this strategy is a Calendar spread, where our intent is to write a front-month call, have it expire worthless, write the next month's call, have it expire worthless, continuing the process as long as our bullish long-term outlook for the underlying stock remains intact.

The primary difference between this strategy and a standard covered call (using the underlying shares as the long side of the position) is that we never want to allow ourselves to be called out of the LEAP. The primary reason is that we have paid a significant amount for our LEAP in terms of time value, and if forced to exercise the LEAP to cover our short call being exercised, we lose all of that excess time value. The better approach if the short call is going to expire in the money (and hence likely be exercised) is to simultaneously buy back the short call and sell the LEAP, completely closing the position. The reason this is preferable is due to the fact that the LEAP (which should always have a lower strike than the short call) will have a higher delta and thus appreciate faster than short-term call.

There's no need for me to cover the details of this strategy here today, as I've done it in a series of Options 101 articles back in June of 2001. While the examples may be a bit dated, the underlying concept and its description is still very much valid. All you need is a security that is in a solid bullish trend. Seen one of those lately? Outside of the Gold sector, about the closest thing I've seen is our current LEAPS Watch List Call play BEAS. For those of you that are unfamiliar with the nuances of the Covered Call strategy using LEAPS (or for anyone that needs a refresher), take a look at the links below.

Covered Calls on the Cheap
Questions on LEAPS Covered Calls - Part 1
Questions on LEAPS Covered Calls - Part 2

As I alluded to above, finding candidates for the LEAPS covered calls strategy is rather tough right now, as there just aren't a lot of upward bound stocks that have an established trend that we can play. With the persistent nature of this bear market, which I believe has more time to run to its eventual conclusion, I've had some astute readers write, asking if the Covered Calls strategy can be turned around and used from the bearish side. Great question!

The short answer is YES. Remember, the practice of buying LEAPS seeks to benefit by riding a long-term trend. Taking a look at the broad market, there's no way to make a rational argument that the long term of the market is anything but down. There are any number of stocks whose charts look very similar (rangebound over the past several months, but still deeply mired in a long-term descending trend. Current LEAPS Watch List put play, GS is a perfect example. Take a look at the weekly chart of the stock and you can see a continuous series of lower highs since September of 2000. With legal problems continuing to rear their ugly head and no sign that the Brokerage industry is going to see a renewed surge in business anytime soon, I expect to see GS break down over the next several months to post new all-time lows.

But the 2005 $70 Put currently costs $1400 per contract, and it's all time value. It would seem to make perfect sense to sell short-term puts against the long-term LEAP to reduce our cost basis. If you have a hard time visualizing the entry and exit points, try turning the chart upside down and then thinking about the LEAPS Covered Call strategy. Then you're dealing with effectively the same approach.

Let's assume that we bought the 2005 $70 LEAP Put (ZSD-MN) as of today's close for $1400. While it may be premature with the weekly Stochastics still recovering towards overbought, it at least gives us a starting point for the discussion. Now that we have our long-term bearish position established, the next task that we're going to want to accomplish is to sell a short-term put against that LEAP, the next time the stock becomes near-term oversold. That could be when GS reaches strong support near $60-62, or when daily Stochastics bottom in oversold, or even when weekly Stochastics bottom in oversold. My preference would be to have all three occur at the same time, as that would make for the best possible scenario. Our $70 LEAP Put would be deep in the money, and we could sell the March-2003 $55 or $60 Put for $150-200 (depending on how aggressive we want to be), with the expectation that it would expire worthless in the third week of March. I'm assuming March contracts, because I expect March will be the front month contract before we see a good opportunity to sell the first covered put.

Assuming that the March expiration cycle goes as planned, then by the end of March or early April, we'll be looking to repeat the process on the next significant bottom in the stock, perhaps with April, but more likely May contracts. Typically this process can be repeated from 4-6 times per year, depending on market conditions. If we can conservatively take in $150 in premium throughout the year, by early 2004, we should have reduced our cost basis in the LEAP Put from $1400 to the vicinity of $650 (assuming 5 round trips during the year). And we still have another year's worth of time value left in the LEAP, giving us plenty more time to repeat the strategy.

Just as with the LEAPS Covered Call strategy, there are a couple of rules that need to be observed when employing the LEAPS Covered Put strategy. First off, never allow the short-term put you have sold to expire in the money. If it is going to expire in the money, close the entire position by buying back the short-term put and selling the LEAP Put. The gains on the LEAP will be greater than the loss on the short-term put, due to the fact that the LEAP will have a higher delta (so long as the strike of LEAP Put is equal to or greater than the strike of the short-term put).

Secondly, we only want to keep the LEAP put open so long as the long-term bearish trend remains in place. If GS were to start posting higher highs and higher lows, it would indicate a change of trend, and employing this strategy would no longer be in our favor. Think again about the Covered Call strategy. It is only beneficial if the stock is in an upward trend. If the stock moves into a descending trend, the premium received from writing short-term calls will only slow the rate at which the overall position loses money. But it WILL lose money! Similarly, the LEAPS covered put WILL lose money if the stock on which it is employed is in a longer-term uptrend, as the underlying LEAP will be consistently losing money. The best way I know of to keep on the right side of the overall trend is to place a rigid stop (it will probably have to be a mental one) which specifies the level at which you will consider the trend of the stock to have changed from bearish to bullish. At that point, we would want to completely exit the position, and look for a different candidate for the strategy that still is in an established downtrend. Coming back to our GS example, if the stock closed above $82, that would be a strong signal to exit the play, as it would have the stock exceeding its highs from both August and December, raising the possibility that the downtrend was over.

It isn't a complicated strategy, buy some traders have a hard time seeing it without standing on their head. Run through some examples on paper, and I think you'll see how easy it can be. Remember, questions are always welcome.


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